Segregated funds

They say that you shouldn’t judge a book by its cover. I think the same applies to investment products.

Segregated funds have some real flaws, but in specific cases, can be very powerful.

Segregated funds are basically mutual funds offered and administered by Canadian insurance companies in the form of individual variable life insurance contracts with certain guarantees such as reimbursement of capital upon death.

They provide an opportunity for someone to invest in the stock market, and if the market goes up, they have an ability to ‘lock in’ the gains. If the market goes down so does the value of the investment although the initial value is guaranteed typically over a 15 year time frame.

The insurance component of segregated funds provides a number of benefits:

There is usually some form of 10 or 15 year guarantee that you will at least get your principal back if you hold the investment for that period of time.

There is some creditor protection so that funds held in a segregated fund are not likely accessible if someone were to sue you.

When someone passes away, if they have named a beneficiary, the assets pass directly to that person, and bypass probate fees on these assets.

In all cases, there is a ‘death’ guarantee, whereby if the owner passes away while owning the funds, there is a principal guarantee of at least 75%. Several companies offer a 100% guarantee on death.

In some cases, there is also an ability to ‘lock in’ a new base for a principal guarantee. This means that if you put in $100,000, and the account is now worth $110,000, you can lock in $110,000 as your new guaranteed amount, but this resets the guarantee time frame. This means that if you hold the fund for 10 or 15 years from the time of ‘lock-in’, or pass away, and the value is less than $110,000 at that time, you will get $110,000.

The last three features are particularly attractive – especially in a volatile stock market. It is ideal for someone who is in their 70s, and possibly not in the best of health.

Here is an example of how we have used this opportunity.

We have a client who was nervous about the market in the spring of 2009 (what person wasn’t nervous at that time). She was 77 years old and had a sizable non-registered investment portfolio. She took $300,000 and invested in equity funds (global, Canadian and small cap). As the investment rose in value, we locked in the gains. Her particular segregated fund enabled us to do this twice a year until age 80. The last time we locked in her fund value, it was over $367,000. If she is holding these funds when she passes away, and the value is $400,000, her beneficiaries will receive $400,000. If the funds are worth $280,000, her beneficiaries will receive $367,000. The reason is that the funds have a 100% death guarantee, and the new guaranteed minimum on the funds is $367,000. In Ontario, she will also avoid roughly $5,400 in probate fees.

If someone is 50 years old, this can still work, but the typical guarantee period will be 15 years. We appreciate that this is a long time to simply break even and that the guarantee has limited value given that the market is highly likely to reflect gains over 15 years. The higher fees also erode some of the benefit.

The reason this makes more sense for someone much older is that it isn’t unreasonable that a 77 year old will pass away in less than 15 years. This shorter guarantee period, along with the ability to lock in a new minimum, and the ability to take bigger investment risks with little downside is a powerful combination for estate planning purposes. For this situation, you don’t want a safe investment. This is where you should be aggressive given the safety net of the guarantee.

Despite a segregated fund being an insurance product, there is no health test or physical required. If someone is 77 and has an illness that will shorten their remaining life expectancy, they could shift some of their investments into segregated funds with a 100% death guarantee (which means that they either gain or get their money back over a short time period) and avoid probate fees.

This scenario demonstrates the value of segregated funds and truth in the expression; you can’t judge all investments by their cover.

Here is a two minute segregated fund video interview hosted by Rob Carrick of the Globe & Mail